Tuesday, February 10, 2009

Sinclair Davidson told the Committee that tax cuts tended to be better at stimulating activity than government spending; they tended to have a higher "multiplier".

He told the committee:

"Professor Gregory Mankiw of Harvard University, who is the author of one of the world’s leading economic textbooks, a former chairman of the economic advisers to the American President George W Bush and a New Keynesian economist, compared the size of the multipliers in an article in the New York Times last month, where he reports on research by Professor Valerie Ramey of San Diego university and Christina and David Romer of Berkeley university, looking at the size of these multipliers. Christina is currently the Chairman of the Council of Economic Advisers to President Obama.

In that research, Christina Romer and her husband find that tax cut multipliers are a size of about 3, and Professor Ramey finds that spending multipliers are about 1.4, which means that the tax multipliers are actually almost twice the size of the spending multipliers. So, if you wanted to have a fiscal impact on the economy, you would be considering tax cuts and not spending increases."

Two points...Mankiw's NYT article compares apples with oranges. Ramey came up with an estimated multiplier of1.4 for government spending under completely different circumstances to those in which Romer came up with 3for tax cuts, and Mankiw has now grudgingly acknowledged that Romer herself thinks this.

Here's what she said in the Q&A she released to respond to the kind of claims made by Mankiw:

"Question: But doesn’t Dr. Romer’s research show that the economic impact of tax cuts is higher than even the Administration is assuming?

Answer: Dr. Romer’s research suggests that all types of fiscal stimulus, both spending and tax cuts, might well have a larger impact than is typically assumed and is assumed in the CEA's analysis. It would be great if that were so...

We cannot afford to play political games with apples-to-oranges comparisons. Such political games distract our attention from the magnitude of the substantive task at hand."

The second point is that Romer arrived at the multiplier of 3 for tax cuts by examining the effect tax cuts had in good times.

In poor times (such as the ones we are in) much more of any tax cuts will be saved - there will notbe a multiplier of 3. My earlier coverage is here.

"Economists’ estimates for the 'multiplier' effect of government spending and tax cuts vary widely, with equally reputable studies showing opposite results. More important, the scale of the global slump means that historical multipliers may not mean very much. That suggests a broad strategy—involving both tax cuts and spending—is prudent."

Tax cuts stimulate both demand and supply. If taxes are lower, they make working today more attractive than working tomorrow, and therefore increase labor supply. This boost to the nation’s productive capacity means that a tax-cut-based stimulus doesn’t do as much to narrow the gap between output and what we can produce.

If you had chosen to quote from my written submission you'd find that I also referred to a study by Mountford and Uhlig who also find tax cut multipliers to be higher than spending increase multipliers.